Over the past decade, US equity funds have eclipsed international equity funds. The Vanguard Total US Stock Fund returned 7.5% per year, while the Vanguard Total International Stock Fund returned only 1.3%. Perhaps this is due to the deep-seated structural obstacles that have arisen in Asia and Europe which have stifled innovation, such as lack of access to cheap financing, rigid employment laws, unfriendly immigration policies, and anti-competitive behavior. Regardless of the reason, the US is on a hot streak.
27 Years of Pain
There are so many reasons to ride the favorable momentum in US-based assets, but there is one reason not to get carried away. In the 1980’s, Japan held the torch as the world’s hottest economy. It’s stock market index, the Nikkei, went parabolic. Japan was at the forefront in manufacturing and technology. They were voraciously buying up U.S. companies and commercial properties. American businessmen and college students learned to speak Japanese so they could communicate with their future Japanese overlords.
Then, suddenly, in 1989, the Nikkei crashed, and 27 years later, it has yet to recover. In fact, the Nikkei is still less than HALF of where it was in 1989. Meanwhile the S&P 500 is up over 600%.
Could the US be the next Japan? I doubt it. The US economy and the US dollar are the envy of the world, and the US will probably continue to outperform. But am I willing to bet the farm on the US? Nope. In fact, since the US represents only 52% of world markets, I would argue that investing 50% to 60% of assets in the US would offer a good balance of profiting from continued US outperformance while easing the pain of the US falling flat on its face for 27 years (like Japan).
My favorite all-in-one fund, the Vanguard Life Strategy Fund, invests 60% in the US and 40% outside the US, while one of my favorite ETF’s, the Vanguard Total World Stock Fund, invests 52% in the US and 48% outside the US.
The 5% Challenge
I recommend a visit to the website of Research Affiliates, an investment strategy firm, that creates fun and free interactive asset allocation tools. They recently released a calculator on their website called “The 5% Challenge.” You input an asset allocation, and the calculator spits out the likelihood that your portfolio will provide a real return of 5% over the next 10 year, based on the valuation, growth, and yield of the assets you choose.
Playing with “The 5% Challenge” calculator for a few minutes makes it clear that what has been blazing hot the last ten years is likely to disappoint in the years ahead. In fact, Research Affiliates estimates that US Large Cap equities will have an annual real return of 1.1% with a volatility of 14.2%, while Emerging Market equities will have an annual real return of 7.3% with a volatility of 22.0%.
With razor thin investment returns ahead, it’s more important than ever to be ruthlessly fixated on keeping investment expenses low. If Research Affiliates is accurate in their prediction that US Large Cap equities will return 1.1% annually for the next 10 years, it would be absurd to pay a 1% advisory fee or a 1% fund expense ratio or 1% in capital gains taxes generated from active management. Investors should aim to pay 1/3 of that. Furthermore, investors should buy a globally-diversified fund like the Vanguard Total World Stock Fund or add a huge slug of the Vanguard Total International Stock Fund to get access to over 6000 companies around the globe, including 30% Asia, 43% Europe, and 19% Emerging Markets for only 0.13% per year.